McDonald's: More Room To Grow?

From the outside, it's difficult to envision how McDonald's Corp. (NYSE:MCD) can grow much at all.

McDonald's restaurants already number 34,000, are located in 120 countries and serve about 68 million people per day, making it the largest chain in the industry.

Over the past decade, McDonald's stock has risen more than 600%, compared with just a 77% return on the Dow Jones Industrials. Yet in 2012, McDonald's was one of the worst performing blue chips stocks, falling 12% in value for the year.

Is There Any More Room To Grow?

Is the mighty Goliath of the fast-food industry starting to topple over?

Some signs point to falling demand for the restaurants it already has. Sales in Asia and Europe have slumped as late, and the combination of food safety scares in the U.K. and China, the growing concern over childhood obesity and the emergence of fast casual dining as a serious competitor doesn't bode well for McDonald's growth prospects.

A key measure used in chain restaurants and retail is growth in same-store sales. This measures how much sales increased or decreased in stores that were operating in the previous measuring period until now. Anemic growth or decline is a signal that demand is slowing, or that the chain in question has overextended itself and is essentially cannibalizing its own business.

This is an area that McDonald's has shown weak results lately. Global same-store sales grew only 0.1% in the fourth quarter, with a 0.3% increase in the U.S., a 1.7% decline in Asia and a 0.3% drop in Europe. During the same period, rival Burger King (BKW) grew its global same-store sales 2.7%, with 3.7% growth in the U.S.

The trend looks to continue for McDonald's. January same-store sales fell 1.9% globally and the company warned that February's numbers would drop about 3% compared with last year.

Not being able to increase sales in existing stores doesn't bode well for expansion. Because of its unique franchise structure, McDonald's needs to continually add stores in order to grow its revenue significantly. Some even suggest that the company is as much a real estate business as it is a fast-food restaurant.

McDonald's owns the physical property of its franchised locations, then leases the space to the franchisees. Currently about 85% of its restaurants are franchise owned, with the remainder owned by the company. The only revenue McDonald's receives from actual food sales in franchised restaurants is a 4% royalty from each franchisee. Therefore, in order to grow its leasing revenue, it essentially has to build more stores and lease those out.

The good news for the company is that its franchise agreements do not include exclusive market agreements. Basically, McDonald's could build its own store a block away from a franchisee or lease another store close by.

Financials

But in the world of investing, the bottom line always comes down to the bottom line. And McDonald's continues to turn profits and return a healthy share of those earnings back to investors.

For the full year of 2012, McDonald's reported earnings per share of $5.36, up 2% from 2011. Revenues modestly increased 2%, while same-store sales globally climbed 3.1% and 3.3% in the U.S. Fourth-quarter earnings of $1.38 a share beat analysts' estimates and were up 4% from the previous fourth quarter.

For the trailing 12 months, the chain comfortably beat the industry averages in gross margin (43.24% to 35.73%), operating margin (30.33% to 18.27%) and pre-tax margin (29.31% to 1.09%). McDonald's has grown its after-tax cash flow by 9% compounded annually since 1998. Its return on invested capital has increased every year since 2002. The company has also earned better returns on its assets and its investments than the industry for both the trailing 12 months and the last five years.

In addition to its reputation for Big Macs and fries, McDonald's also has a history of being a steady stock in which to invest. With a beta (beta being a measure of price fluctuations) of only .34, the share price does not move around much.

What's more, the company has a generous dividend, currently paying out about 54% of net income to its shareholders (compared with around 30% of the average S&P company). McDonald's has increased its dividend in each of the past 36 years. According to the DRiP Investing Resource Center, it is one of only 100 companies that have increased dividends annually for at least the past 25 years.

The generous dividend concerns some analysts. It doled out 72% of its $3.9 billion in free cash flow generated during the last four quarters back to shareholders. Ten years ago, it allocated just 25% of its free cash to dividends. Adding to the concern is the fact that the company has not been able to improve its cash position for the last three years, remaining relatively flat at around $2.3 billion.

The Positives

But because of its ability to earn profits, many don't see reasons that McDonald's dividend prowess won't continue.

Those bullish on the stock also point out that the company may be undervalued. Based on current price-to-earnings ratios, McDonald's is a better value (P/E ratio of 17.85) at its current price than key competitors Burger King (54.91) and Wendy's (NYSE:WEN) (306.11).

And while short-term prospects appear sluggish, many are bullish on McDonald's long-term horizon. The company expects to grow annual sales by 3% to 5% and operating income by 6% to 7%. In 2013, McDonald's plans to invest about $3.2 billion to open between 1,500 and 1,600 new restaurants and to reinvest in our existing locations, including re-imaging more than 1,600 locations worldwide.

Another way to grow is by acquisition. McDonald's attempted this avenue in the 1990s by acquiring majority stakes in Chipotle Mexican Grill (NYSE:CMG), Donatos Pizza and Boston Market. A decade later, it returned to focusing on its core brand by divesting itself of these brands, and did so at enormous profits. There are no signs the company is interested in going down that road anytime soon.

So you can either believe the giant of the industry can grow larger and continue to earn profits and pay out dividends to reward investors. Or you take the stance that given its size, maturity and the changing dynamics of the industry, McDonald's has about reached its limit on the number of burgers, fries and shakes it can sell.

Additional Disclosure: Catalyst Investments is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. This information is not investment advice or a recommendation or solicitation to buy or sell any securities. Catalyst Investments does not purport to tell or suggest which investment securities readers should buy or sell. Readers should conduct their own research and due diligence and obtain professional advice before making investment decision. Catalyst Investments or anyone associated with Catalyst Investments will not be liable for any loss or damage caused by information obtained in our materials. Readers are solely responsible for their own investment decisions. Investing involves risk, including the loss of principal.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: This article was written by an analyst at Catalyst Investments.